Wednesday, June 30, 2010

"Berkshire May Be Required To Post Up To $8 Billion In Collateral" (BRK.A; BRK.B)

I think it was Boston University's Zvi Bodie* who, shrugging off the restraints of his MIT PhD, pointed out to the "expected return" crowd that if it were true that the risk of negative returns decreases as the time frame increases, the cost of long-term puts should decrease the farther out you go.
Kind of an Emperor has no clothes thing to say.
I'm referring, of course to the equity index puts that Mr. Buffett sold.

From ZeroHedge:
Some bad news for Uncle Warren. In a note by Barclays' Jay Gelb, the insurance analyst evaluates the impact of FinReg on that "other" company and concludes that as a result of Berkshire having $62 billion in notional derivative exposure, the additional collateral requirement contemplated in the current version of Financial Reform (don't worry, the corrupt idiots in Congress will strip it before all is said and done), which amounts to 10% of notional, or 100% of option proceeds, would result in $6-8 billion in collateral posting requirements imposed on "America's Company." Even for Buffett, this is not purely chump change.
From Barclays:
  • As a financial entity, we believe Berkshire Hathaway will be classified as a major participant and not be grandfathered for avoiding additional collateral requirements.
  • Buffett said at Berkshire’s annual meeting in May 2010 that, if needed, he believes BRK could use existing investments including equities as collateral rather than cash, although it is unclear to us how much additional collateral would be required.
  • Notably, derivatives used by Berkshire’s MidAmerican & Burlington Northern operations as end-user hedges appear to be exempt from clearing requirements, but would be subject to margin requirements, although non-cash collateral is permitted to be posted.
  • Reiterate 2-EW rating on Berkshire Hathaway. We anticipate strong results in Manufacturing, Service, & Retail and Burlington Northern, stable results in Insurance and Utilities, and choppy investment results. Additionally, we believe headwinds to BRK’s book value growth in 2Q include anticipated mark-to-market impacts from falling equity markets, exposure to Goldman Sachs warrants, and potential mark-to-market derivative losses. Long term, we remain concerned about a lack of clarity around Warren Buffett’s succession plans because we believe he is synonymous with Berkshire Hathaway.
  • BRK.B currently trades at 1.34x 1Q10 BV (2.0x tangible BV), which is below its historical median of 1.7x (historical range: 1.1-2.7x). Our $88 price target is based on 1.3x YE 2011E BV of $69. Based on our assessment of potential investment marks, our current thinking is that Berkshire’s linked-quarter book value per share could fall 1-2% in 2Q10.
Here is some backgrounf on Berkshire's existing derivative exposure:
Berkshire Hathaway is party to approximately 250 derivative contracts with a total notional value (the nominal exposure to a derivative’s underlying securities) of $62 billion at 1Q10 and an average contract life of 11.25 years (details provided in Figure 1). These contracts generate substantial float for Berkshire of $6.3 billion as of year end 2009 since Berkshire collects premiums at the inception of the contract. Similar to insurance float, if Berkshire breaks even on the underlying contract, it has enjoyed the use of free money for years (although the company expects to perform better than breakeven). Warren Buffett considers himself the chief risk officer at Berkshire and is in charge of monitoring derivatives positions.

Berkshire Hathaway has attracted unwanted attention due to its growing derivatives exposure. The company increased its exposure to fluctuating investment valuations by selling long-dated put options on equity indexes and high yield indexes as well as credit default protection for states/municipalities and individual corporations with a total notional value of $62 billion. On a positive note, these contracts provided Berkshire with $6 bn of float for investment, the contracts cannot be settled prior to expiration, and the marks reversed to positive territory after 1Q09.

Economic risk from Berkshire’s derivatives appears manageable, in our view. This is because the equity put options are European style (only exercisable just prior to expiration), and require payment by Berkshire in about 11.25 years (on a weighted average basis) if the index price is lower than the level when the contract was written. Notably, in 2009 Berkshire reduced the strike prices and shortened the maturities of about 10% of its equity put options. That being said, Berkshire’s derivative contracts enhance its exposure to equity markets as well as to the debt service capabilities of states and municipalities in a challenging fiscal environment.

Berkshire’s derivatives contracts produce meaningful accounting swings in net income due to marking these securities to market each quarter. As a point of reference, Berkshire estimates a 30% increase in equity markets could result in about a $2-billion accounting gain in its equity put options, and a 30% decrease could result in about a $3 bn accounting loss (1.5% of shareholder’s equity). Berkshire’s cash at 1Q10 was $23 billion, which approaches Buffett’s internal minimum requirement of $20 billion.
But before you start worrying that the principle of return and risk apply equally to Berkshire know this: Warren is confident all is good....MORE
*William Bernstein (No slouch either, M.D. Neurologist, PhD. Chemistry, dabbler in Modern Portfolio Theory, Bestselling Author, etc.) in one of his Efficient Frontier pieces, "Zvi Bodie and the Keynes’ Paradox of Thrift" described the professor as "Academician, raconteur, and all-around good guy Zvi Bodie...".

Then he rips his lungs out. Very typical in the academy:
...What’s wrong with mass-market inflation-protected intermediation? Unfortunately, everything. First, TIPS, while relatively risk-free in the long run, can be rather nasty actors in the short run. As of this writing, the 29-year bond yields a real 2.7%; the 10-year bond, 2.1%; and the 5-year bond, 1.5%. To get those returns, the investor has to be willing to take about 12%, 6%, and 3% of (standard deviation) risk, respectively—not chopped liver, particularly at the long end. Bodie makes the same mistake here as his foils James Glassman and Kevin Hassett, who in Dow 36,000 postulated a new species of homo economus impervious to short-term volatility. At some point in the future, there will be a grinding bear market in TIPS (it may already have begun!), and it is a forgone conclusion that tens of millions of savers will sell out at the bottom, just as they have done historically and repeatedly with stocks. 

But there’s an even more fundamental problem with TIPS as the national core investment: lack of supply. When investors purchase stocks, they are syndicating corporate investment risk by allowing the companies’ owners to offload risk onto them in exchange for a risk premium. In effect, they are acting as companies’ insurance agents. With TIPS, the situation is far more complex, but mainly in the opposite direction. Here, it is the seller who is assuming risk, indemnifying the buyer against the risk of inflation. For the Bodie plan to work, the government, corporations, insurance companies, and mortgage suppliers must be willing to underwrite trillions of dollars of inflation-protection risk for retirement savers. Whether this is even feasible is anyone’s guess, but what is certain is the price paid by investors for such an amount of protection would be enormous. 

Bodie sagely points out that stocks do indeed become more risky with time, the proof of the pudding being that equity puts become more expensive with maturity, and not the other way around. The same, unfortunately, is true of inflation risk. Similar to stock puts, the nominal yield curve is usually positive, for exactly the same reason: with time, the risk of inflation rises. While one may be reasonably certain that we shall not see hyperinflation in the next five years, one cannot be so sure about the next three decades. Insuring against inflation for the next 30 years is a dandy idea and, at the moment, it is even reasonably cheap. But if demand mushrooms, prices will rise and yields will fall. In an extreme case, negative yields in the secondary market for Treasuries and in the primary non-government markets are entirely possible. (For those having a hard time imagining a negative TIPS yield, imagine what coupon would have been demanded by investors in Germany and Hungary in the 1920s for an inflation-protected investment.)

As pointed out by Rob Arnott and Ann Casscells in the January-February issue of Financial Analysts Journal, stocks and bonds are merely a medium of exchange between retirees and workers. (In January, I discussed the Arnott/Casscells argument in these pages.) At any point in time, there are x number of workers producing goods and services for y number of retirees. If there are too many retirees and not enough workers producing goods and services for them, it does not matter how well the retirees have saved in the aggregate—their standard of living will fall as the prices of their securities—TIPS included—deteriorate and the wages of workers rise. 

The grim reality is that improvements in intermediation of the sort suggested by Bodie, while helpful, cannot avoid being overwhelmed by the twin bogeymen of human financial nature and demographics....